Puerto Rico has triggered the biggest municipal default in US history

A homeless man in front of a closed fast-food restaurant in the colonial district of Old San Juan, Puerto Rico, on Sunday. Ricardo Arduengo/AP Puerto Rico has triggered the biggest municipal default in US history, risking years of bitter legal warfare with creditors and an austerity "death spiral" with echoes of Greece.

The island commonwealth finally ran out of money on Monday after a desperate effort to stay afloat, missing a final deadline for a $58 million payment — handing over just $628,000.

It implies a sweeping default on much of its $72 billion debt burden, equal to 100% of Puerto Rico's gross national product (GNP) and more than five times the debt ratio of California or Texas.

The commonwealth is now in legal limbo, facing a well-organized pack of hedge funds that scooped up the debt at distressed levels and appears determined to extract maximum value in the courts, even if this means shutting down part of the island's education system and social services.

Puerto Rico is not covered by the "Chapter Nine" bankruptcy code in the US, and therefore it cannot resort to the sort of orderly debt restructuring that helped the city of Detroit to get back on its feet after defaulting in 2013.

By a quirk of law, it does not enjoy the partial protection of full US states. At the same time, it is unable to draw on support from the International Monetary Fund since it is not a sovereign country.

Telegraph

"We don't know how the bankruptcy is going to proceed. It could easily turn into a free-for-all," said Desmond Lachman, a former IMF division chief now at the American Enterprise Institute.

"If the hedge funds press for their pound of flesh, they could drive the economy into the ground," he said. "The more the economy tanks, the less tax they collect, and the more they have to tighten. It is crazy."

Telegraph

"They are in a similar situation to Greece," he said, "and this is what happens if you are asked to carry out too much fiscal adjustment in a fixed exchange monetary union. Their GDP has been shrinking by 1% a year for the last decade."

A group of 34 hedge funds, led by Fir Tree Partners, among others, has recruited a team of former IMF officials to push their case that Puerto Rico is able to pay its debts if it reins in public spending.

They say the island is "massively overspending" on education, letting costs balloon by 39% over the past decade even though school enrollment has collapsed by a quarter. The island has already closed more than 100 schools.

Telegraph

Puerto Rico's governor, Alejandro García Padilla, said dramatic austerity would perpetuate the island's "vicious cycle" as the shriveling economy accelerates a mass exodus of the working-age cohort. The population has collapsed by 12% in a decade.

"This is not about politics. It's about maths," he said. "We have to make the economy grow. If not, we will be in a death spiral."

Puerto Rico has recruited its own IMF champion, the former deputy director Anne Kroeger. Her report implicitly calls for a debt haircut of 35%, roughly the current price of debt trading in the secondary market, though there are many types of bonds. Others say debt relief nearer 50% will be necessary.

"There is no US precedent for anything of this scale and scope," she said. "No US state has restructured its debt in living memory. Any attempt faces unprecedented legal challenges."

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Kroeger said it would be self-defeating for creditors to push their demands too far given the vast fiscal gap that has built up over time. "There are limits to how much more expenditures can be cut or taxes raised," she said. "One has to be mindful of the hit to near-term growth from a sharper fiscal contraction; if output falls significantly, tax receipts will decline."

Several bills are now emerging in Congress that would grant Puerto Rico "Chapter Nine" protection and weaken the hand of creditors. Presidential candidates Hillary Clinton and Jeb Bush have called for legal changes, all too conscious that this saga has become a neuralgic issue for Hispanic voters — a key swing constituency.

Yet the creditors have pushed home their narrative that Puerto Ricans are feckless, living beyond their means, and could easily pay if they tightened their belts. Great numbers of ordinary Americans bought the island's debt because the interest was tax free.

Telegraph The parallels with Greece are striking, though they can be pushed too far. Nobel economist Paul Krugman says Puerto Rico is cushioned by fiscal buffers, pension payments, and medical care under the US federal union, averting the sort of collapse in incomes seen in Greece.

Puerto Rico clearly allowed a debt crisis to creep up during the boom years, when the underlying rot was hidden from view and creditors lent without a second thought, banking on an implicit guarantee from the US sovereign state that did not in fact exist.

Yet it was also the victim of globalization, or the "China effect," which chipped away at mid-level economies caught too far down the manufacturing ladder, with relatively high wages and low productivity. Puerto Rico was unable to compete against this Asian onslaught after a special tax sweetener expired in 2006.

The Kroeger report said the island should be exempted from the US minimum wage to restore competitiveness, a de facto call for an internal devaluation — an experiment pursued with varying results in Greece, Portugal, Latvia, and Ireland.

For the world, Puerto Rico is becoming a test case of whether hedge funds and financial creditors can legitimately dictate terms to sub-sovereign states, or whether there is a greater social interest in limiting their legal powers.